In most cases, you’re considered a cash-basis, calendar-year taxpayer. This means you deduct expenses in the year you pay them, even when the cost covers expenses from another period. Cash-basis taxpayers don’t prorate any expenses on a tax return. However, if you own a business and use the accrual method of accounting, you must prorate some prepaid expenses and claim only the amounts that you have incurred or used. Accrual-basis taxpayers deduct expenses when they’re incurred, so if you prepay a monthly expense, you wouldn’t deduct the cost for future months because the expense hasn’t been incurred yet.
Prepaid expenses are either regular monthly bills or services you benefit from on a monthly basis. When you pay for these things in advance, you’re making a prepayment for the good or service. Examples of these expenses are prepaid insurance, subscriptions and rent. When you calculate your year-end expenses, you’ll want to prorate any prepaid expenses that you haven’t exhausted by the last day of your tax year. Most small-business owners choose a calendar tax year, even if the accrual accounting method is used. If this is the case, your business tax year ends on Dec. 31, just like your personal tax year.
Even when you prepay an expense, your business recognizes a monthly expense for the service. When you prorate expenses, you’ll need to figure out the monthly cost for the service. This typically is the amount you’d pay every month if the bill wasn’t paid in advance. For example, if you pay six months of insurance up front, divide your total prepayment by six. The result is your monthly insurance cost.
Months of Use
After you determine the monthly rate for your prepaid expense, you’ll need to calculate the number of months your business actually received the service before the end of the tax year. Count the number of months included in your prepayment through the end of the year. For example, if you purchase an annual magazine subscription for your business Sept. 1, you get four months of the subscription during the year if your business’ tax year ends on Dec. 31.
Calculating your prorated amounts is easy once you know the monthly rate of your service and the number of months you used the service during the year. Simply multiply the number of months used up by your monthly rate. The result is the prorated expense to report on your annual business tax return. You’ll deduct the rest of your expense the following tax year.
With a background in taxation and financial consulting, Alia Nikolakopulos has over a decade of experience resolving tax and finance issues. She is an IRS Enrolled Agent and has been a writer for these topics since 2010. Nikolakopulos is pursuing Bachelor of Science in accounting at the Metropolitan State University of Denver.